The last thing investors need is a contested election
Below is a lightly edited transcript of the podcast:
CHRIS WALLACE: All right, gentlemen, final segment, election integrity. As we meet tonight, millions of Americans are receiving mail-in ballots or going to vote early. How confident should we be that this will be a fair election, and what are you prepared to do over the next five plus weeks? Because it will not only be to election day, but also counting some mail-in ballots after election day. What are you prepared to do to reassure the American people that the next president will be the legitimate winner of this election. In this final segment, Mr. Vice President, you go first.
JOE BIDEN: Prepare to let people vote. They should go to iwillvote.com, decide how they’re going to vote, when they’re going to vote, and what means by which they’re going to vote.
HELTMAN: This is an excerpt from the tail end of the first presidential debate from September 29, a discouraging affair for all concerned. But I brought up this unpleasant memory because this question from Fox News’ Chris Wallace about the integrity of the election and the peaceful transition of power — a question that typically doesn’t need to be asked — is starting to emerge as a critical source of risk to the financial system. And part of the reason for that is because the president answered that question, in part, like this:
DONALD TRUMP: Don’t tell me about a free transition. As far as the ballots are concerned, it’s a disaster. A solicited ballot, okay, solicited, is okay. You’re soliciting. You’re asking. They send it back. You send it back. I did that. If you have an unsolicited… They’re sending millions of ballots all over the country. There’s fraud. They found them in creeks. They found some, just happened to have the name Trump just the other day in a wastepaper basket …
TRUMP: They have mailmen with lots of it. Did you see what’s going on? Take a look at West Virginia, mailman selling the ballots. They’re being sold. They’re being dumped in rivers. This is a horrible thing for our country.
BIDEN: There is no … There is no evidence of that-
TRUMP: This is not going to end well.
BIDEN: There is no evidence of that-
TRUMP: This is not going to end well-
TRUMP: I’m urging my supporters to go in to the polls and watch very carefully, because that’s what has to happen. I am urging them to do it. As you know, today there was a big problem. In Philadelphia, they went in to watch. They’re called poll watchers, a very safe, very nice thing. They were thrown out. They weren’t allowed to watch. You know why? Because bad things happen in Philadelphia. Bad things. And I am urging my people. I hope it’s going to be a fair election. If it’s a fair election-
WALLACE: You’re urging them what?
TRUMP: … I am 100% on board. But if I see tens of thousands of ballots being manipulated, I can’t go along with that. And I’ll tell you why-
WALLACE: What does that mean, not go along-
TRUMP: … from a common sense-
WALLACE: Does that mean you’re going to tell your people –
TRUMP: I’ll tell you what it means-
WALLACE: … to take to the streets?
HELTMAN: Finance in general and banking in particular is about taking risks and appropriately pricing and hedging those risks. And banks are attuned to all kinds of different risks, from credit risk to operational risk to interest rate risk to liquidity risk. But over the last several months, many banks and financial companies are grappling with something they haven’t had to think about very much, at least not in the United States: political risk.
So what is political risk, and how does it work? What does a disputed election — or, really, anything other than a traditional, peaceful transfer of power — mean for banks and financial markets? What is the outcome that banks and bankers want out of this election? And how does the government — whoever is in power come January — reduce political risk going forward?
From American Banker, I’m John Heltman, and this is Bankshot, a podcast about banks, finance and the world we live in.
HELTMAN: I said did you watch the debate last night?
KAREN PETROU: No, and I'm glad I didn't. And I ... Basil and I both said we wouldn't be able to sleep afterwards. That was before we even knew what it was like. What did you think?
HELTMAN: I didn't … I didn't watch. I was just like, I turned to my wife, and I was like, “So what do you think? Do you want to watch the debates?” And she's like, “No.” Like, this is not ... let's just save ourselves that tedious, depressing spectacle that obviously going to be.
PETROU: Oh, it was more than now. Obviously, it was more than that. It's funny, because I'm glad you called. I had been getting as I mentioned in my emails, you know, questions from clients about this and then after the debate, I really thought it was a ... a necessary thing, because Brexit is sort of an analogy to this, where nobody thought it was going to happen, and then it did. The markets, particularly the foreign exchange markets, went nuts. But there are a lot of issues here for the nation that's the leader of the free world.
HELTMAN: Please welcome back to the show Karen Petrou.
PETROU: Karen Petrou, Managing Partner, Federal Financial Analytics.
HELTMAN: When we talk about political risk, what we really mean is a risk to an investment that is political in nature. And it’s a very broad term, encompassing everything from the risk of higher taxes to the risk of armed insurrection. And banks — particularly those that operate overseas — think about political risks all the time. But traditionally, the term has been meant to denote a certain kind of risk coming from a certain kind of place.
PETROU: I was hired by Bank of America to be essentially the corporate political scientist. This was in the late 70s, because I'm old, and there were an array of political risks that would just beginning to surface. My job was looking at countries like the Congo, where it was so clearly unstable. There were civil wars. And there was ... most of it, actually, was, you had the post-colonial powers with a tremendous amount of corruption, but [making] efforts at growing their economies and therefore trying to entice global banks. And you really have to say, “Is this, you know ... how long is this despot going to make it versus the one who's trying to kill him?” Those kinds of analyses. But they were not a ... they were not geopolitical scale. We understood the U.S., Canada and Europe very well — we thought — and because of the dominant power of the dollar, the dominant power of American banks and the dominant importance of NATO, political risk was really isolated.
GREGORY DACO: In general, when we think about political risk, we think about the uncertainty that pertains to political development.
HELTMAN: This is Gregory Daco.
DACO: Yes, my name is Gregory Daco, and I'm Chief U.S. Economist at Oxford Economics. Private-sector actors and investors are generally not fond of uncertainty, that uncertainty related to a political environment can make their decisions be delayed, whether it's reducing investment today or reducing consumption today or investing in a much more cautious way. All these decisions reflect an increase in, in in political risk and political uncertainty. Now, in today's environment, we are seeing this idea of political risk, with tremendous uncertainty as to the outcome of the elections, but also as to how the transition of power may occur if there is one, after the presidential elections, and some of the uncertainty pertaining to presidents Trump's desire to proceed to a smooth transition, should he lose the election is one of the key risks, key uncertainties and key worries when it comes to the next few weeks on the markets front, but also on the business investment front.
HELTMAN: There has been political risk in the United States before, Daco said — different political outcomes lead to more or less favorable laws or policies for various businesses. But to understand what’s different now, you have to understand the types of political risks out there and the spectra of possible negative outcomes associated with those risks.
DACO: There are really three tiers of risks. There's the traditional ex ante uncertainty related to elections, and that tends to happen anytime there's an election, unless there is clear evidence or indications that one candidate will win a long time in advance. And that's usually rare. So typically, we have that first tier of political uncertainty in the lead-up to elections. So that, we're past. Then there is the uncertainty as to the actual result, and when that result will be declared. And that's the second tier of uncertainty — that uncertainty as to whether we'll get a result on Election Day, or on the night of the election, which increasingly seems unlikely because of the number of people voting by mail, given the current pandemic. So that's the second tier of uncertainty, and I think that's largely priced in by markets. I think there is an expectation that we won't get results between maybe a day or two or maybe a week, at most, after the elections.
But then there is that third tier, and that's the really risky tier. In that in that third tier, you have the possibility of a prolonged period when the administration — the current administration — may declare the results of the elections to be a fraud. There may be a wait until December 14, when the Electoral College votes are submitted and counted. And who knows, there may be even a step further, where the current administration would essentially attempt to get the Supreme Court to declare the winner. So we are right now pricing in that second tier of uncertainty, which is one of a slight delay in the announcement of a result. And in a sense, that is somewhat similar to an environment in which you're just getting a slight delay. If we were to move on to that third tier, that is the area where you can have a big effect on economic activity on social activity, social unrest. And that is where some of the historical precedents might serve as a guide. TheGore v. Bushsaga, that is a good guide, I think, as a first level in that tier three. But you could go even beyond that, if neither of the two candidates refuses to acknowledge defeat.
HELTMAN: And the prospect of a contested election — and, more to the point, the very wide array of ways that the election could be contested and social disruptions that could ensue — brings with it a lot of uncertainty. And uncertainty is bad for investment, and by extension, bad for banks. But is this just theoretical, or are markets already anticipating that uncertainty? And, to paraphrase Leo Tolstoy, happy elections are all alike, but unhappy elections are all unhappy in their own way. How do you price in such a wide range of possible outcomes — from delayed results to a breakdown of social order — if the election is contested?
DACO: There are a series of policy uncertainty indices that essentially study the amount of uncertainty that's present, whether on the pure policy front — there's the economic policy uncertainty index — or on the trade front, or on the legal front. So essentially, what these indices tried to do is capture the overall amount of uncertainty that there is in any given point in time, and one of the interesting features of the current environment is that we have seen an unprecedented surge in the uncertainty. It's not just related to the election, it also is related to the uncertainty surrounding the health crisis that we're living through. But all these factors combined have led to this unprecedented surge in the level of policy uncertainty. From a markets perspective, you can also perceive that uncertainty and that worry about the risk in some of the volatility indices that show that volatility is on the rise, and that there are worries, especially over the next month, month-and-a-half.
ED MILLS: You know, I've been in DC for 20 years now. I've been doing the Washington policy job for more than a decade. I've never had an election where I've had to spend any time on alternative scenarios, different curveballs. I've never spent time talking about a contingent election. I've never really had to drill down into exactly how the Electoral College works, or the voting count works, or any of the election law questions that have come up. And I think that kind of shows you how extraordinary of a time we're in.
HELTMAN: This is Edward Mills.
MILLS: Edward Mills, Washington, policy analyst at Raymond James.
HELTMAN: In addition to the volatility indices that Gregory Daco just described, there are also derivatives and other various instruments that companies can buy to hedge against volatility. And what Mills is seeing is an unprecedented demand for those hedging instruments going into the next several months, as evidenced by the prices of those instruments going through the roof.
MILLS: So if you think that there's going to be volatility you buy Vol. And so if there is volatility — if there's big moves up or big moves down, by owning that option, you get paid off, based upon exactly what you buy, what is the spot price, what is the implied vol that you're purchasing. To get that insurance ... essentially, to purchase election insurance on and around November 3, is extremely expensive.
HELTMAN: Because, like, people don't want to sell it, I imagine.
MILLS: Well, just because it ... you know, it is a tail risk. But the Yeah, the growing concern is that if it is a close election, the ability to know who won with any degree of confidence — especially in such a polarized environment — has a potential chain of events that no one wants to deal with, you know, from a political perspective, or from a market perspective.
HELTMAN: So if uncertainty is bad and this election is brimming with uncertainty, what outcome are banks and other financial firms rooting for? Well, I actually have a bit of insight into that, and I’ll share that insight with you after this short break.
HELTMAN: This is my colleague Janet King.
KING: Yes. Hi, I'm Janet King. I'm the Vice President of Research for Arizent.
HELTMAN: And Arizent, of course, is the mothership of American Banker. So tell us about this survey that we did.
KING: So this was an online survey that we conducted among the audiences that we reached through American Banker and other media brands. So it was an online survey conducted between September 17 and September 22, and it was us business leaders and professionals who are employed at banks, payment firms, mortgage lenders, insurance companies, municipal finance agencies, and accounting firms and the like. And we had a total of 1,200 individuals respond to the survey, which is a really nice large sample size.
HELTMAN: The survey asked readers of American Banker and other Arizent publications questions about which candidates and parties they preferred to win the Presidency, the Senate and the House, but went on to ask them about which election outcomes they thought would be better for their industries, which outcomes they thought would be best for the country, and which outcomes they thought were most likely.
There’s a kind of conventional wisdom about the financial world’s attitude to politics, and that is that financial firms and markets prefer divided government. The reasoning behind that conventional wisdom is that if no one party runs the entire government, fewer bills get passed — and the ones that do tend to be less drastic, meaning the political risks are mitigated. But that isn’t what Janet’s survey found.
KING: The polarization that we're seeing across the United States electorate, was definitely reflected in those questions around the best and most likely outcomes. Among registered Democrats, they definitely felt that a Biden win would be best for the industry best for the country, and also the most likely outcome. We saw a similar sentiment among registered Republicans, who felt a Trump win — some combination of that — would be best for the industry best for the country [and] most likely outcome. Independents were more split. So they tended to be almost split down the middle on who would be best for the industry in the country. So they were kind of, you know, half blue, half red. And they were leaning a little bit towards Biden for the predicted outcome.
But I think what was surprising among that was not really that we are, you know, seeing people line up with their party affiliation, but that the percentage of both registered Democrats, Republicans and independents who thought that a sweep would be most beneficial, was really high. So it wasn't only the Democrats wanted a Biden win and Republicans wanted a Trump win, but they wanted to see control of the White House, the Senate and the House of Representatives all in the hands of a single party, thinking that consolidation of power would be best for the industry and best for the country.
HELTMAN: That’s a pretty dramatic change, when you think about it. For most of the 20thcentury — which is to say, for most of the history of the modern financial system, the biggest political risks in the United States were whether bills that made your investments less profitable might get passed. And those kinds of bills historically did get passed, both under divided government and unified party control. But now so little gets done under divided government that even routine legislative business like passing a budget, keeping the government from shutting down, even raising the debt ceiling are laborious unless one party has all the marbles.
IAN KATZ: There's a bit more comfort, generally in divided government, but not a dysfunctional government.
HELTMAN: That’s Ian Katz.
KATZ: Ian Katz, I'm a financial policy analyst and director at Capital Alpha partners in Washington. Capital Alpha is an independent policy research firm. You do want to have a government that you have confidence can pass bills, like the CARES Act, and then, you know, this with the current stimulus, I think there's … there's differences of opinion here. But, you know, there's some people who view the inability to pass another stimulus as being dysfunctional. They view that as not good for markets, not good for the economy. I do think there's a difference between divided and dysfunctional. Divided can be good because in a lot of investors’ minds it prevents the most extreme outcomes. But dysfunctional, it means that, like, when you really need to pass something, you can’t pass something. And I think that's, that's a different story.
HELTMAN: But what’s important here isn’t that bankers have changed their views on politics: it’s that those attitudeshadto change after at least a decade of escalating partisan conflict, brinksmanship and dysfunction, culminating — possibly, in the next few weeks — in an unresolved election and constitutional crisis.
KATZ: The certainty or uncertainty of the election outcome is important, particularly over the long term. Because if people don't trust people in the United States and people in other countries ... it matters, what investors or the markets think. If they think that we have a process that's too capricious, or arbitrary or unfair — or just not certain, but particularly unfair and absolutely unpredictable — then that does, over time, undermine confidence in U.S. markets. I'm not saying that's happening, but it could happen. It could happen over time. And, you know, foreign investors in particular — but also U.S. investors — will, over time, look at that longer-range thing, like, “I can't invest in X, because I don't know, what's going to happen to it. I don't know if it's going to be fairly or unfairly punished by the government.” So when you have elections where you're questioning, you know, just thelegitimacyof the outcome, we are harder to distinguish from a lot of other countries where that's more ... where that's historically the case.
HELTMAN: The federal government hasn’t been working the way it was designed to for a long time, but a contested election might signal a new era of American finance. In a bad way.
PETROU: No other country is the world's reserve currency. This is one of the really big issues that I fear: if the instability goes on for too long, the fundamental view of the United States dollar as risk-free. We flirted with “breaking the buck” in that way before, when the government debt ceiling was in danger. But this is different. It's not, “What happens to the debt ceiling?” in the midst of this, which is one big issue. Just, what happened to the government? The government's … the continuing resolution goes to December 11. Do we have a government shutdown if we don't have a functioning Congress? We know that Donald Trump would still be president. Where's he? What's going on? What … what chaos are we in? But you never used to have to think about that …
PETROU: ... before. We were a sovereign power.
HELTMAN: There is some recent experience elsewhere with these kind of big surprises in political risk. The election of Donald Trump in 2016 was one, where the stock markets crashed before rallying again. Another, perhaps more fitting, example is the Brexit vote in the UK from June 2016.
PETROU: Brexit was really the first example of that, where a country that everybody felt was well-governed by the rule of law — rule of law is … one of the big issues in political risk management is understanding countries without rule of law, because then political changes of government means changes of everything. But we never thought that was true in Britain until Brexit, and we'd never thought that was true in the United States until now. It was just a sudden dissolution of what everybody thought was the known order of international finance across what had been, then, the undissolved European Union. But there was no question of, “Was David Cameron still the Prime Minister?” Absolutely. When he decided that he lost the country's confidence, and they called an election, that proceeded in an orderly fashion. This is different. And the foreign exchange markets, the derivatives market, the value of the dollar — and Treasury obligations representing it — were theoretically unquestionable. And I think that's why you see a lot of banks and other financial institutions, basically, sort of like people who live in a bunker, you know, laying in a whole lot of trail mix bars. They're laying in a whole lot of liquidity ahead of potential market turmoil. And one of the big reasons for that is expect to see considerable chaos in the foreign exchange market.
HELTMAN: But on the other hand, we’ve seen these kinds of scares before. Gregory Daco, the economist from Oxford Economics we spoke to earlier, said these political risk concerns are real and certainly are making a difference on the margins, but at least for the foreseeable future the entire global economy is denominated in dollars — and this election isn’t going to change that.
DACO: The US market remains one of the deepest one of the most liquid markets in the world, if not the most liquid and most … the deepest market. But it also is important to note that the U.S. dollar remains the preferred currency for a number of factors. Whether it's trade, whether it's investment, most of that activity around the world is done in U.S. dollars. And so I don't necessarily see that changing anytime soon because of what's happening today. If you look back at the, say, the last 10 years, and you look back at 2011, when S&P downgraded the U.S. from its AAA debt rating, everybody was saying, “Well, that's going to have quite a significant negative effect on the safety or the perception of a safe haven in U.S.-dollar-denominated assets.” That did not take place. Everybody fled into … into the U.S. Dollar. The U.S., despite its troubles, despite its political dysfunction, still retains that status, which is somewhat independent of the political environment. It's more related to, you know, what people use — what people invest in, and how they invest, and how they go about their regular activities, which determines this safe haven status.
HELTMAN: But if the United States wants to keep that confidence in its currency, and if it wants to continue to be the home of the deepest and most liquid markets in the world, that cause is not furthered by having a dysfunctional government. Politicians come, and politicians go — that’s the system of government that created the conditions for those deep, liquid markets in the first place. But changing the current political climate with all this uncertainty into a more reliable one is a tall order. A government that can’t agree on a budget isn’t likely to agree on broad rebalancing of power. But here’s a start.
MILLS: One of the ways in which you instill more confidence is turned down the temperature. We have been — for a number of years, and I'm sure we could get into great debates as to who started it — but each kind of election seems to turn up the temperature. And it seems to create scenarios in D.C. where there is greater incentive for winner-take-all legislative and regulatory battles. And especially following a scenario where you felt the other side to use whatever they could do when they were in power to implement their agenda, it's really difficult to say, “Now that I'm in charge, I'm not going to do the same.” And so we've had the American people reward parties, electorally, for continuing to promise a pretty wide divergence from policy perspectives, based upon the upcoming election. And so it is ultimately the responsibility of the … the American voter to choose someone who is going to turn down the temperature. It's a real question on whether or not that's even possible in a largely two party system.
HELTMAN: Right now it seems like the United States could go one of two ways: resume a political path of free elections and popular democracy, or embark on some despotic decline. And the truth is, democracies die all the time. Dictatorships do too. What tends to make the difference is what the people themselves want and what they expect.
KATZ: I lived in Argentina from ‘90 to the end of ‘94. And in late 1990 like some group of disgruntled military guys, like, went out in tanks in the street to demand like, I don't know what. Maybe to demand, you know, maybe certain things get done, but they weren't really trying to take over the entire government, although some people thought that at the time. But it was more like a barracks uprising than a coup. But it was definitely like, you know, a big deal. So by coincidence, or not, George H.W. Bush, president at the time, was coming to Argentina on a visit, and he's speaking to the Argentine Congress, and he's giving a speech. And in the middle of the speech, Argentina had one socialist lawmaker, one, you know, representative. I still remember the name, Luis Zamora. And he starts yelling something about imperialism and U.S. and, you know, all that stuff about us being imperialistic power and evil and all that.
ARGENTINE CONGRESS/TRANSLATOR: We can’t give anybody the floor, sir. We can’t give anybody the floor, I’m sorry. On behalf of the Argentine people and of their representatives …
KATZ: And, and everybody is like, you know, booing him, the other members of Congress are booing, and they're, like, telling him to sit down, and telling security to take them out. And Bush — and obviously, he didn't know, this was, you know, going to happen — says …
GEORGE H.W. BUSH: And lest you be embarrassed by the … echo we heard at the opening of this ceremony, don’t worry about it. Every once in a while you hear an echo from the declining past of Marxism. And … but that is the price we pay for democracy. Let’s pay that price. I feel welcome here, and thank you all very, very much.
KATZ: I was watching, I was like, "Yeah, he totally gets it! That's awesome!” You know, like, “Wow!” And the, this is my recollection is the Argentines are just like ... they still, like, carted them out of there. They didn't like ... they just hauled his ass out of there. They didn't get it the way that you know, the President did. And like, to me that was like, that was like a moment. I was like, this is why, you know, America is a great country because it's like just you know, like, because we like believe stuff like that. And we … we, you know, we walk the walk, and we talk the talk.